BEYOND THE CHART · CHAPTER 05
Options Pricing, Volatility & Greeks
The learner can explain the main factors that affect option premiums, define implied volatility, understand time decay, describe the basic Greeks—delta, gamma, theta and vega—recognise volatility crush, explain why predicting underlying direction is not enough for option trading, and treat options pricing as an educational framework rather than a recommendation or guarantee.
Option premiums are influenced by multiple factors
Identify the main influences on an option’s price.
An option’s premium is not based only on the underlying price. Major influences include the underlying price, strike price, time to expiration, expected volatility, interest rates and dividends. Changes in any of these can move the option’s value, even if the underlying price does not move.
Implied volatility is derived from option prices
Define implied volatility.
Implied volatility, or IV, is the volatility input that an option-pricing model backs out from current option prices, usually expressed as an annualised percentage. It is often interpreted as the movement magnitude embedded in market pricing, but it is model-dependent and is not a direct or unbiased forecast. Higher IV generally corresponds to higher option premiums, all else equal.
Historical volatility is different from implied volatility
Distinguish historical from implied volatility.
Historical volatility, or HV, is calculated from past price movements. Implied volatility is backed out from current option prices and reflects future expectations. They can differ because the market is pricing in events or uncertainty that the past may not capture.
Time decay erodes extrinsic value
Understand how time affects option premiums.
Options lose time value as expiration approaches. This process is called time decay. It accelerates in the final weeks and days before expiration. All else equal, an option’s extrinsic value is lower with less time remaining.
Delta measures sensitivity to underlying price
Define delta.
Delta estimates how much an option’s price may change for a $1 change in the underlying price. A call delta is often between 0 and 1, while a put delta is often between -1 and 0. Delta is not fixed and changes as the underlying moves and time passes.
Gamma measures how fast delta changes
Define gamma.
Gamma estimates how much delta changes when the underlying price moves. High gamma means delta can change quickly as the underlying moves. Gamma is often higher for near-the-money options and near expiration, making price sensitivity more dynamic.
Theta measures time decay
Define theta.
Theta estimates how much an option’s price may decline as one day passes, all else equal. Theta is usually negative for option buyers, because time decay works against them, and positive for option writers, because they may benefit from time passing.
Vega measures sensitivity to implied volatility
Define vega.
Vega estimates how much an option’s price may change for a one-point change in implied volatility. Higher vega means the option is more sensitive to volatility changes. Long options generally have positive vega; short options generally have negative vega.
Volatility crush is a sudden IV decline
Explain volatility crush.
Volatility crush occurs when implied volatility falls sharply, often after a known event such as earnings or a binary catalyst. Even if the underlying moves in the option buyer’s favour, the drop in IV can reduce the option’s price enough to cause a loss.
Predicting direction is not enough
Understand that option outcomes depend on more than direction.
For an option buyer, being right about direction is only one part. The size, speed and timing of the move matter. Time decay, implied volatility changes, the distance from the strike and the premium paid all affect the outcome. A correct directional view can still lose money.
Long and short option perspectives differ
Compare buyer and writer exposure to the Greeks.
Option buyers generally benefit from favourable underlying movement and rising IV, while they are hurt by time decay. Option writers collect premium and may benefit from time decay and falling IV, but they may face large obligations if the underlying moves against them. The signs of the Greeks often reverse between buyer and writer.
Theory boundaries and personal responsibility
State what this educational chapter does and does not provide.
This chapter explains how implied volatility, time decay and the Greeks affect option pricing. It does not recommend buying or writing options, predict option prices, or provide trading strategies. Options pricing models are simplified representations and may not capture every real-world condition.